The biggest boom will be the unavoidable one

Adapting to climate change is going to cost many trillions. Yet so far, only a trickle of money is being put towards it. What is causing this baffling blockage in financial markets, and how can it be unlocked?

  • By Jon Hay
  • 15 Oct 2019
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The financial markets of the 21st century will be climate change adaptation markets.

So far, investment in technology and services to help humanity live with climate change — as opposed to trying to slow it by cutting greenhouse gas emissions — has been slight. But the scale of the needs, and the gravity of global warming’s effects, are awesome.

Consider these predictions from the World Resources Institute for the effects of a 1.5C rise in temperature. Water scarcity will affect 270 million people. Forty-eight percent of people will be exposed to more than 20 days a year of deadly heat by 2100. Flood damage losses from sea level rise will be $10tr a year.

Yet it would take a miracle for the world to escape with only 1.5C of warming. At the moment, 3C or higher looks more likely.

At 3C, permafrost collapses and rainforest dies. Droughts will average 10 months. Three quarters of people will face 20 days of deadly heat a year.

There can be no doubt that finding ways to live in these conditions will be the economic challenge of this century, as well as the dominant political and social issue.

One might think this would mean investment firms and banks were pouring trillions of dollars into funding solutions to these perils. Not so. A report by the Climate Policy Initiative could only find $22bn of global investment in adaptation in 2016.

“There is a market failure,” says Lorenzo Bernasconi, who runs the innovative finance and impact investing portfolio of the Rockefeller Foundation in New York. “If you look across all global commitments — the Sustainable Development Goals or the Paris Agreement or business needs — we are facing unprecedented challenges, whether from climate change, degradation of resources, income inequality, mass migration. There is a need for a step change in the quantum and direction of investment, but money is not flowing at anywhere near the level necessary.”


Markets paralysed

There are several causes for this immobility. Known since the 1970s, the risks of climate change have been largely ignored by most of society until recently. A deep-seated human bias towards optimism makes it very difficult to accept that the planet we rely on for life may be threatened.

In supposedly rational financial markets, this translates as the horizon problem. “If you think there is a likelihood of impact even 10 years out, but your investment horizon or policy horizon is two years, you may defer today things you should be doing,” says Stacy Swann, CEO of Climate Finance Advisors, a consultancy in Washington.

“And that assessment of 10 years is probably not true. Warming is not only accelerating, but the climatic change and feedback loops are happening in ways that had not been fully predicted.”

Belatedly, efforts have begun to “mitigate” climate change, as the jargon has it, by reducing emissions. This has spurred rapid growth in new industries such as solar and wind power, electric vehicles and LED lighting. But the need for adaptation remains neglected.

Although sea levels are rising and hurricanes, floods and drought are becoming common, there are no stock market darlings making investors rich with solutions to these problems.

“Adaptation is a very poor cousin at the moment,” says Xianfu Lu, a climate scientist who is head of analytics at Acclimatise, a UK-based consultancy.

Some of the reasons are structural. Adaptation is harder to finance than mitigation. It is much more difficult to know now what infrastructure will be needed, and where.

Because the climate is global, any investment anywhere in reducing carbon emissions benefits the whole planet. With adaptation, it is the other way round. Climate change will have very specific effects in different places, which can only be addressed with the right investments on the spot.

That influences motivation, too. With mitigation, there is a global incentive to invest everywhere. With adaptation, selfishness presents a higher barrier. Citizens of large countries may not care much if distant islands become submerged.

Just as difficult is the problem of cashflow. Renewable energy plants and energy efficiency measures produce an immediate financial return — either a saleable product or a saving.

With adaptation infrastructure, there can be a large upfront cost and no obvious revenue. The benefit is that businesses and citizens can carry on as normal, or closer to normal, and this may be appreciable only in future.


Both sides reluctant

Besides these fundamental difficulties, there are many more specific ones. Lu highlights three. “If you talk to the big investors they ask you: ‘Where are the investments?’” she says.

“The projects are not there. If you ask public sector people ‘If money was no object, if I had a billion to invest, what would you do with it?’ people have a hard time to come up with a ready answer.”

If demand to make investments is lacking, so is the material to invest in. “The supply of resilience solutions, products and services is still not there, partly because of the capacity of the providers,” she argues. Most are not big enough to “get up to scale, replicate, offer services to different geographies, particularly in developing countries”.

Lu’s third complaint is that “the attractiveness of investments in adaptation is not well established. There is a lot of work to be done to demonstrate the business case.”

The result is that, very often, the default option prevails: do nothing.

Meanwhile, the cost of climatic damage is rising. 2018 was not a record year for damage from catastrophes. Nevertheless, Munich Re counted $80bn of insured losses, a third higher than the average of the previous 10 years. Uninsured losses add another $80bn.

“The one figure we find staggering,” says Swenja Surminski, head of adaptation research at the Grantham Research Institute on Climate Change and the Environment at the London School of Economics, “is that, of all the money spent on extreme events and disasters, 88% goes on repairs and reconstruction, and only 12% into making things more resilient.”

There are powerful reasons why people tend to stay idle till calamity strikes. When a community is wrecked, the needs for spending, public and private, are precise and compelling.

Trying to ward off risk in advance, when you don’t know where, when or how it will hit, is much harder. “You can’t touch resilience, that’s the crux of the matter,” says Surminski. “When you try to make it an investable proposition, you are facing this issue: ‘how can I quantify the resilience benefit?’”


Beginning to stir

Despite its dismal record so far, the financial system has at last woken up to adaptation and resilience.

“Two major things have happened in the past 12 months,” says Jay Koh, co-founder of the Lightsmith Group, a private equity firm in New York. “There’s been a growing recognition that climate change is a reality here and now. We’ve had hurricanes impact on Houston, the Bahamas get hit, Pacific Gas & Electric go bankrupt because of wildfires. Investors are coming to grips with the fact that it’s a humanitarian problem and a financial risk that impacts on the performance of different assets.”

The second “dawning recognition”, Koh says, is “that there is an opportunity to invest in products, services and solutions that can deal with that impact”.

A milestone was the publication in September of the first report of the Global Commission on Adaptation (GCA). It gives the issue A-list cred — its co-chairs are former UN Secretary-General Ban Ki-moon, Kristalina Georgieva, who has just moved from president of the World Bank to managing director of the IMF, and Microsoft entrepreneur Bill Gates.

But more than that, it bumps adaptation from being a worthy but difficult item on the list in every climate change discussion to a new status — a headline issue of compelling urgency.

The GCA is calling on all sectors of society to join a Year of Action to jumpstart change on eight tracks, including food, natural environment, water and finance.


Eyes on risk

An essential thrust is to “make climate risks visible in private financial markets”. This is a central piece of the puzzle. For many actors, identifying and managing risk will be a precursor to financing adaptation.

“A lot of people in financial businesses are thinking more about the opportunities,” says Swann. “But if you haven’t fully understood the risk, you are not going to be able to understand the opportunities, either. Even if you are a consumer buying a house, you should understand the risks.”

While the insurance industry houses and uses deep knowledge of physical climate risks, banks and investors are at square one.

Through initiatives such as the Task Force on Climate-related Financial Disclosures, they are feeling their way to building a discipline of climate risk management. But there is a severe lack of knowledge, and minimal guidance from the authorities on what to do.

A research paper written for the GCA by Climate Finance Advisors covers financing adaptation. It lays bare the barriers at every step in the financial system, from insufficient public financial support to scanty incentives for the private sector, to weak regulatory frameworks.

Financial regulators, the report charges, “have focused heavily on capital reserve and leverage ratios, derivatives trading… but not climate risks as yet”.

“It’s not just a question of financial and non-financial firms saying ‘we’ll do this’,” says Craig Davies, head of climate resilience investments at the European Bank for Reconstruction and Development in London. “There’s also a need for regulators to start requiring it. They are starting to set supervisory expectations, saying to banks and asset managers: we expect you to show that you can stop concentrations of these risks.”


Getting going

Financiers need not wait for regulators to push them. They can get started on adaptation investing and climb over many of the barriers.

The EBRD has been concertedly financing adaptability since 2012, signing 250 climate-resilient investments totalling over €7bn. Of that, about €1.8bn of the money is specifically for adaptation needs.

About 80% goes to infrastructure — energy, water, transport and urban. “Infrastructure tends to involve long term, fixed assets which are very expensive to change, once in place,” says Davies. “They will have to operate over many decades and shifting climate conditions, so it makes a lot of sense to think about whether they will be climate-resilient.”

In a dry region of central Asia, the EBRD has financed the conversion of a thermal power station, which was piping water 40km to cool itself, to an air-cooled system. In Bosnia, hit by devastating floods five years ago, it has invested in roads built to withstand extreme weather.

Another 15% of the EBRD’s financing is for the corporate sector, and this is likely to grow. “It could be manufacturing, agricultural processing, extractive, IT, a whole range of services — there is a growing awareness in the corporate sector of physical climate risks,” Davies says.

“Climate-related shocks in extreme cases can knock out businesses. But it can be secondary impacts on value chains. Some commodities could become much less available and more expensive.”

In 2011, severe floods in Thailand forced a Honda car factory to close for six months. Toyota and Nissan’s factories were not inundated but they had to close for a few weeks because parts suppliers had been knocked out. They lost 400,000 cars between them.

“Nissan recovered more quickly than other auto companies because it had dissolved the keiretsu [cross-shareholding] system, diversified sources of supply, and globalised the procurement system,” wrote M Haraguchi and U Lall in a study in the International Journal of Disaster Risk Reduction.

This is exactly the kind of planning that will have to become second nature to companies as the weather gets rougher. Linear supply chains will be replaced by more flexible networks.

Backing the winners

Deliberately seeking to buy into companies that stand to profit from climate change might seem at first a shocking idea. On close examination, it is not only wise but beneficial.

“The need for technologies and solutions to assess and address the impact of climate change will drive demand for increased investment, and that investment opportunity is both attractive and very important,” says Koh.

“There are companies that already have technology that can scale up to meet the size of the impact. We want to scale solutions as fast as we can, to address the problem, which is growing very fast.”

Lightsmith Group has researched 800 growth companies around the world, with $5m to $100m of revenue, whose products or services relate to climate resilience. They span 20 mini-sectors, which in total have $130bn of current spending — supply chain analytics, business continuity, water analytics, water efficiency, drip irrigation, drought-resistant seeds, remote imaging…

Releasing the hang-ups

Little by little, advanced investors are wearing away some of the obstacles: dearth of projects to invest in, lack of solutions to implement, perception that the risk is unattractive.

Davies says that, contrary to the cliché, there are often strong commercial reasons for private players to invest in resilience. “There are streams of revenue that can be derived, often against a counterfactual,” he says. “For example, if you can have a reasonable degree of certainty that your port is not going to be closed due to unfavourable weather 10 days a year, but only one, that is valuable.”

And resilience investments do not just achieve direct effects. “When you talk to finance ministers, or in the private sector, people are always focused on trying to provide protection for something, or on their return on investment,” says Surminski. “You shouldn’t look at it only through that lens, but see it as investing in economic development and growth.”

This triple dividend includes avoiding losses when disasters strike; stimulating economic activity thanks to lower risk of damage; and extra development gains on the side.

Planting mangrove forests in Indonesia, for example, reduces flood damage — but also improves farmers’ incomes and locks in nutrients and carbon. The total benefit of one project in Indonesia was estimated at three to 18 times the money invested. High returns like these are common for resilience investments.

Nevertheless, many problems remain. One is that, for all the good work being done, hundreds of infrastructure investments are still being embarked on without any thought of making them climate-resilient. They are, in fact, making the problem worse.

A worrying possibility is that the more investors think about climate risk, the more they may tend to shun the regions, industries and communities in the front line.

“The most vulnerable are going to get hit first,” says Swann. “People say it’s already happening from the physical side — I mean the financial side. Countries could have less access to capital than they did 10 years ago. This is going to put greater pressure on public balance sheets, whether governments or development banks, just at the time when the actual investment need far surpasses their capacity.”

New problems, new solutions

Many believe the only way to bridge this gap is with financial invention, combining capital sources with different missions and risk/return expectations.

The Rockefeller Foundation is deep into this work. Bernasconi at the Foundation likens it to the emergence of venture capital and private equity funds in the 1950s and 1960s.

At Cancun on the Mexican coast, Rockefeller partnered with the Nature Conservancy and Swiss Re. Over two years they persuaded a group of beachfront hoteliers to take out what Bernasconi calls “the first insurance mechanism for nature”.

“Because of the increased frequency and intensity of Atlantic hurricanes, the reef is being destroyed,” says Bernasconi. “But in the 24 hours after a storm you can repair it. Nature is much more effective than manmade structures — 97% of a storm surge is absorbed by a healthy reef.”

Without the reef the hotels are at risk of losing all their beach equipment, and the beach itself — they are already paying millions of dollars a year to pump sand that has been washed away. A 40 mile stretch of the beach now has insurance for this hurricane season.

Adaptation investment is starting in many places. It takes in highly bespoke structures like Rockefeller’s; loans to build new ports with higher docks; banks deciding whether Volkswagen or Renault is better fitted for electric mobility; pension funds wondering which global banks are least exposed to fossil fuels. Very soon, every investment will be an adaptation investment.

“There is an absolute need for this to be a priority,” says Koh. “In 10 years it will be obvious that the scale of the climate change problem is much bigger. We will have seen multiple cities with water crises, impacts on agricultural productivity. The question is: will we have invested in solutions or not? Investors that choose to do so have potential for growth. If society does, it will have a much better chance of managing the problem.”

  • By Jon Hay
  • 15 Oct 2019

All International Bonds

Rank Lead Manager Amount $b No of issues Share %
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1 JPMorgan 353.47 1629 8.35%
2 Citi 326.07 1388 7.70%
3 Bank of America Merrill Lynch 283.34 1182 6.69%
4 Barclays 259.26 1043 6.12%
5 HSBC 207.22 1150 4.89%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $b No of issues Share %
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1 BNP Paribas 39.66 183 7.00%
2 Credit Agricole CIB 37.82 159 6.67%
3 JPMorgan 30.63 81 5.41%
4 Bank of America Merrill Lynch 26.33 79 4.65%
5 Deutsche Bank 26.03 96 4.59%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $b No of issues Share %
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1 JPMorgan 11.22 75 9.54%
2 Morgan Stanley 10.77 52 9.16%
3 Goldman Sachs 9.63 50 8.19%
4 Citi 7.78 60 6.61%
5 Bank of America Merrill Lynch 5.53 30 4.70%